Advanced Corporate Finance - Coursework Example

ADVANCED CORPORATE FINANCE QUESTIONS By Advanced Corporate Finance Questions Part a (I) According toModigliani and Miller (1961), the market imperfections such as differential tax rates influence the way investors perceive capital gains and dividends and, for this reason, some investors prefer capital gains to dividends. Therefore, where dividends are subjected to high personal tax rates firms would prefer to pay the lowest cash dividends possible and utilise the remaining cash to repurchase shares. The relationship can be well explained by the relationship between dividend yield (DY) and the return of firm’s share, which results in U-shape or non-linear relationship, implying that the DY has a negative relationship to a firm’s common stock return. For instance, firms with high yields or zero dividends have the highest returns an implication that a firm or shareholders would prefer capital gains to dividends because they result in higher returns (Wolf, 2000). Conversely, Elton, Gruber, & Blake, (2005) argue that differential tax treatments are the causes for less than one dividend drop ratios (DDR). Thus, through their research on the relationship between taxes and a firm’s decisions, they articulate that in a rational market, the ex-dividend cutoff should reflect the value of capital gains and dividends to a marginal shareholder. However, when tax enters into the investors’ decisions, the fall in share price in the ex-dividend should show the price of the post value capital gains relative to the post value of dividends. Therefore, because of the influence of tax differential rates, on the capital gains and dividends, the DDR will be less than one because of the fall dividend values due to higher taxation as a result of the effect of personal taxes (Elton, Gruber, & Blake, 2005). Therefore, this impact will influence the firm’s decision in terms of contributions to capital gains and dividends. Part a (II) There are other factors that like tax influences the decisions of a firm to either pay dividends or capital gains. The availability of growth opportunities for investment require that firms plough back their profits to invest in projects with positive NPVs as illustrated by the signaling hypothesis lieu of paying or increasing their dividend payout, which sends a negative signal to the investors. The stability of earnings is another factor. Firms that have a constant earnings are likely to pay out dividends unlike firms with lower or unstable earnings whose dividend payout is likely to result in the decline of growth of their earnings (DeAngelo, DeAngelo, & Skinner, 1996). Thus, such firms would prefer capital gains to dividends to avoid sending a negative signal to the market in the event they withdraw paying their dividends in future due to low earnings to boost their returns. The shareholders’ expectations is another significant factor that influences a firm’s decision whether to pay dividends or repurchase shares. Shareholders often expect management to declare dividends to earn from their investment. Therefore, management often considers paying dividends to shareholders lieu of repurchasing shares to avoid alienating the shareholders. Ultimately, a firm decision to pay dividends or repurchase shares is influenced by the accessibility the firm has to capital sources according to the excess cash hypothesis (Grullon, and Michaely, 2002). Issuing shares involves huge costs in the form of floatation costs that makes re-issuing of shares a costly endeavor. Therefore, firms will prefer retaining their profits to investment in projects with positive NPVs lieu of re-issuing shares and thus would avoid paying dividends to finance such activities. Part b (1) Personal taxes influence the optimal capital structure of a firm from the perspective of the relativeness of corporate and personal taxes’ impact on the returns of debt and equity. For instance, it is important to note that investors experience different rates of personal tax on their capital gains and equity income. A good example is the UK, where the rates of personal tax are such as 40% and 45% while that of capital gains is 28%. Therefore, this implies that investors will often prefer capital gains to income because of the higher tax rates personal is subjected to, which has an adverse overall impact on the capital structure of the firm. Moreover, Graham (1999) through his cross-sectional company’ payout differences argues that the discrimination in personal income tax’s interest payment alleviates the corporate leverage available to the company and thus influencing the optimal capital structure of the firm. Conversely, Miller (1977), through his model that incorporates personal income in determining the optimal structure of a firm’s capital, argued that under the existing concessions in personal taxation of equity income, there exist no optimal structure of capital for any company. In essence, Miller articulates that the value of a levered firm under the effect of personal taxes is equal to the value of the unlevered firm added to the tax gains resulting from debt an implication that there is no optimal structure for a firm under the M&M with personal taxes (Miller, 1977). Part b (II) Modigliani and Miller’s tradeoff leverage theory argue that leverage has benefits within the structure of capital up until when the optimal level of capital structure is attained. Therefore, the theory recognises the benefit of the tax, which results from the interest payments that are tax allowable. Thus, a firm will continue to add debt to its capital structure to a point when it can offset its tax liabilities. According to Modigliani and Miller (1963), the deduction of interest enables the firm to obtain a debt tax shield, which increase its value. Therefore, unlike an unlevered firm, a geared firm can continue use debt to attain an optimal capital structure where it can settle its tax obligations. On the other hand, an unlevered firm cannot benefit from the advantages of tax allowable expenses of interests because it does not have debt in its capital structure. Thus, corporate taxes have an influence on a firm’s capital structure in that it influences the management’s decision to consider to finance the firm’s activities using debt or equity finance. However, because of the benefits of tax shield debts, firms often resort to financing projects with positive NPVs using debt to obtain such advantages to avoiding costs associated with the issuing of new shares. Ultimately, it is evident corporate taxes unlike personal taxes influence the optimal capital structure of the firm because a firm can only borrow up to the point where it’s able to offset its tax obligations. References DeAngelo, H., DeAngelo, L., & Skinner, D. J., 1996. Reversal of fortune dividend signaling and the disappearance of sustained earnings growth. Journal of financial economics, 40(3), 341-371. Elton, E. J., Gruber, M. J., & Blake, C. R. (2005). Marginal stockholder tax effects and ex-dividend-day price behavior: Evidence from taxable versus nontaxable closed-end funds. Review of Economics and Statistics, 87(3), 579-586. Graham, J. R., 1999. Do personal taxes affect corporate financing decisions?. Journal of Public Economics, 73(2), 147-185. Grullon, G., & Michaely, R., 2002. Dividends, share repurchases, and the substitution hypothesis. The Journal of Finance, 57(4), 1649-1684. Miller, M. H., & Modigliani, F., 1961. Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-433. Miller, M. H., 1977. Debt and Taxes*. the Journal of Finance, 32(2), 261-275. Modigliani, F., & Miller, M. H., 1963. Corporate income taxes and the cost of capital: a correction. The American economic review, 433-443. Wolf, M. (2000). Stock returns and dividend yields revisited: A new way to look at an old problem. Journal of Business & Economic Statistics, 18(1), 18-30. Read More